St. Louis Federal Reserve Chairman James Bullard, one of the more hawkish members of the Fed’s regional banking governors, reiterated at an event Monday that the Fed must hike rates “quickly” to curb inflation. (Inflation hawks typically push for higher rates, while so-called doves prefer lower rates to spur growth.) Bullard suggested the Fed could hike rates by as much as 75 basis points.
Fed Chair Jerome Powell has started sounding much more hawkish in recent weeks, but he may not want to be as aggressive as Bullard would like. But it’s clear that interest rates are likely to move much higher soon.
“The Fed should have taken the opportunity to raise rates earlier. There’s only so much you can do now, it’s almost too late,” said Johan Grahn, Vice President and Head of ETFs at AllianzIM. “But they have to preempt that and unfortunately the recipe for that is to be more aggressive with raising rates.”
Traders are now pricing in a nearly 100 percent chance of a half-point hike at the Fed’s May meeting, according to the closely watched Federal Funds Futures trading on the CME, and a more than 25 percent chance of another 50 hike Base points in June.
Investors are also pricing in a more than 70% chance that the Fed will hike rates by three-quarters of a percentage point in June. That would keep the Fed’s short-term interest rate at 1.5%, a dramatic increase since the beginning of the year when interest rates were near zero.
It cannot be overstated how unusual it would be for the Fed to raise rates by such a large margin. The last time the Fed raised interest rates by half a point was in May 2000, when Alan Greenspan was Fed chairman, just after the dot-com bubble peaked. The last three-quarter-point increase was also under Greenspan in November 1994. (Greenspan retired in 2006.)
According to José Torres, Senior Economist at Interactive Brokers, the Fed is in a tough spot right now.
“They have to tighten up fast and pray nothing breaks. It’s the only policy they have,” Torres added. “Being so late in raising rates reduces the Fed’s flexibility.”
Bond investors have already discovered that interest rates can only go up. The benchmark 10-year Treasury bond yield is now hovering near 2.9%, up from around 1.5% at the end of 2021. That has put upward pressure on mortgage rates, with a 30-year fixed home loan now averaging a rate of 5 has %.
Fears of recession are increasing
Higher interest rates could eventually slow the red-hot housing market, but that could take a hit to the broader economy.
That’s exactly what happened when the Fed aggressively raised rates to 20% in the late 1970s and early 1980s under the late Paul Volcker to combat double-digit inflation. The result was a double-dip recession, then a brief downturn in 1980, followed by another pullback that lasted from mid-1981 to late 1982.
With this in mind, the Fed must be ready to pivot quickly to reverse damage from higher rates, which the Fed has done in the past. For example, it started cutting interest rates in July 1995. And in 2001, after a massive stock market crash, the Fed reversed course and cut interest rates a whopping 11 times.
Jenny Renton, a partner at Ruffer, an investment management firm, worries that the Fed is likely to be too aggressive in raising rates as it belatedly tries to put inflation toothpaste back in the tube.
She is concerned that Fed rate hikes could lead to a recession. And that would mean the Fed might have to cut rates again quickly, leading to more volatility.
“People are talking about the Fed making a policy mistake, but that has already happened. The Fed was way behind the curve on inflation. Now they have to respond to recessionary pressures,” she added.
Others, however, think the Fed should focus more on inflation concerns than concerns about an eventual slowdown. Finally, the job market remains tight, with an unemployment rate of just 3.6%… not far from a 50-year low. And the Fed has what is called a dual mandate: it must focus on both price stability and maximum employment.
“I believe that [the Fed] takes its mandate very seriously,” said Brad Conger, deputy chief investment officer at Hirtle Callaghan & Co., in an email to CNN Business.”
“Before the war, it seemed plausible that inflation would gradually come down to the 3% range. With the impact of war and a now foreseeable Covid outbreak in China, we would be lucky if consumer price inflation stayed below 5%,” Conger added.